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Putting your money in funds investing overseas can be a frustrating and confusing experience as currency movements can either wipe out or increase your investment returns.

No sector has been more challenging for UK investors over the years than Japan, which has been beset by deflation and an overvalued currency. The high value of the yen in itself is not a problem for UK investors, but it is for Japan's exporters whose shares have languished as their products become expensive for foreigners to buy.

Recently, however, all this has begun to change with the election of a new government in Japan which has started to force down the value of the yen.

And Japan funds that hedge (or limit) their exposure to the yen by using derivatives have captured the dramatic rally in the Japan stock market that has ensued.

Hedged Japan funds leap up the tables

Investors in funds that offset their exposure to a falling Japanese yen, but have benefited from a stock market rally in the country, have enjoyed gains of up to 30% over the past few months.

Currency-hedged funds targeting Japan have been the best performers over one month and three months, the latest Citywire data shows.

This is because they have benefited from a decline in the yen brought about by the election in December of prime minister Shinzo Abe (pictured above). He has promised aggressive action to weaken the painfully high currency that has hurt the country's exporters by making their products expensive for customers outside Japan to buy.

Abe’s rally

Japan’s Nikkei index has moved in the opposite direction to the currency, hitting its highest level in almost three years on Tuesday. Abe’s government has announced a massive fiscal stimulus programme, while keeping up the pressure on the Bank of Japan (BoJ) to produce its own monetary stimulus.

But Abe needs a victory at Upper House elections in the summer to ensure safe passage for his reforms. Long-term Japan watcher Andrew Milligan, head of global strategy at Standard Life Investments, emphasises the need for structural reforms to sustain investor interest. ‘Reforms are obviously needed, when you get big players like Panasonic and Sony beginning to implode under the pressures that they’re facing this I think is a very strong warning to the Japanese establishment that changes need to be made.

Political motivation

In a country of repeated broken economic hopes, there is scepticism about Abe’s ability to carry through his electoral promises.

Paul Chesson, who runs Japan funds at Invesco, has told Citywire that Abe is playing politics. ‘Mr Abe doesn’t have a majority there at the moment and he wants one. So he is going to use all of his economic strategy and policies in order to get one. These are issues that are politically positive but do not lead to fundamental change,' he said.

Milligan is also sceptical about the long-term impact: 'Is it simply going to be a cyclical run? [A case of] Let’s do some short-term public sector spending, let’s move the yen to try to remove some of the pressure on company profits, and actually we get a very nice six-month run in Japanese equities and the yen but that’s all it is at the end of the day’.

Don't let yen get too weak

In fact in recent days the yen decline has been halted after comments from Japanese economy minister Akira Amari that an excessively weak currency could make imports too expensive – counteracting the gains from cheaper exports for Japanese companies.

Veteran Japan watchers are long used to disappointment from a stagnant and indebted economy. The optimists called the end of the multi-year bear market last year, when the Nikkei moved sharply higher for a couple of months – only to fall back sharply again. This has become an annual sport.

Since then though, the general trend has been upwards, before starting to rally strongly in December.

Though optimistic of Nikkei gains in 2013, Hiromichi Tamura of Japanese bank Nomura said a short-term ‘adjustment’ was due after the recent rally: ‘We expect investors to become more selective heading toward the quarterly results season in late January as they start to focus more on valuations.’

Hugh Young, the Citywire AA-rated Asia Pacific fund manager, says his team at Aberdeen Asset Management has been 'warming a bit more to Japan' but is 'far from making a wholesale commitment' to investing in the country.

Investors in the Ruffer Investment Company – a popular investment trust with a long-standing 23% bet on Japanese equities – will be among those hoping ‘Abenomics’ holds the key to stock market success. ‘The combination of a change of leadership at the BoJ and a possible loss of independence means that there is reason to be optimistic that Abe can succeed where previous administrations failed,’ says the latest investment update from Ruffer.

Hedging your risks

The latest Citywire data shows that the best performing Japan-focused fund over both one month and three months was the sterling hedged version of the Invesco Japanese Equity Core fund , run by Paul Chesson. The fund, which was only launched in June 2012, returned 17.8% over the past month, and 31% over three months.

Going back further, you don’t find these currency-hedged funds, so you can’t check the three year performance record that Citywire uses to rate fund managers or pick funds for our Citywire Selection list.

It is clear why currency-hedged funds – which remove the currency risk in the country you invest in – have in recent months outperformed rival funds which aren’t protected against a sudden decline in the yen.

But amid the uncertainty in Japan, which includes Upper House elections and a forthcoming change of central bank governor – and bearing in mind the unpredictability of currencies in general – it’s a brave forecaster who says definitively that the yen will move in a particular direction.

Citywire's Japan picks

Our analysts take the view that this is partly because over the long-term currency movements tend to even themselves out, rendering hedging a potentially expensive 'zero sum' game.

Also the currency hedged versions that have done well recently haven’t been around long enough to convince our fund-pickers yet. However, this is an issue that Jonathan Miller, Citywire's head of research, and Frank Talbot, our senior analyst, will address next month when they update their recommendations in time for the end-of-tax-year ISA season.

I disagree with the figures quoted, your own tables show that the GLG fund and Legg Mason Japan are both up about 8.5% over 1 year. Where as LM Japan is up 65% over 3 years compared with GLG only up 6% over the same time span.